Mortgage Reform Is Worth the Small Extra Cost to Borrowers

Phillip Swagel is a professor at the School of Public Policy at the University of Maryland and was assistant secretary for economic policy at the Treasury Department from 2006 to 2009.

In the current housing financing system, shareholders and management of Fannie Mae and Freddie Mac got the considerable profits in good times, and when the housing market collapsed, taxpayers were stuck with the bill — a $190 billion tab in the recent crisis.

A Senate proposal for a new system would have private investors rather than taxpayers take on most of the risks and returns involved with mortgage lending — if a misguided obsession with the small additional cost to borrowers doesn’t sink the reforms.

The proposal put forward recently by Senators Tim Johnson, Democrat from South Dakota, and Michael Crapo, Republican from Idaho, who lead the Senate banking committee, would bring about a housing finance system driven first and foremost by market incentives rather than by government dictates.  There are many pieces to the proposal, including support for affordable housing and an innovative approach by which to reward financial firms that serve a broad range of customers and penalize those that do not.

But reducing the government involvement in housing finance and bringing back private capital is at the heart of the bill, which would end the anomalous situation in which the housing finance giants Fannie Mae and Freddie Mac are private companies that earn enormous profits but remain under the control of a government regulator.

Building on an earlier effort by Senators Bob Corker, Republican from Tennessee, and Mark R. Warner,  Democrat from Virginia, the Crapo-Johnson legislation reduces taxpayer exposure to housing risk by requiring private investors to risk their own capital in an amount equal to 10 percent of the value of the mortgages receiving a government guarantee. The government would then sell secondary insurance on mortgage-backed securities composed of qualifying home loans (with underwriting protections written into the legislation). As mortgages go bad (which they do even in good times), the private capital would take the first losses and provide a buffer against the need for the government to put out cash on its guarantee.

The 10 percent capital requirement is large enough to protect taxpayers. Fannie Mae and Freddie Mac together in the crisis suffered losses of about 4 percent of the value of their assets, meaning it would take an economic upheaval considerably worse than that of the last seven years to burn through the private capital protecting taxpayers. In exchange for the increased role of the private sector, the existence of the secondary government backstop would ensure that mortgages remained available to Americans across financial market ups and downs.

Adding this protection for taxpayers has a cost, since private investors require compensation to take on housing risk. This translates into higher mortgage interest rates for borrowers.

Before the financial crisis, advocates for reforms were sometimes attacked as “antihousing,” on the grounds that the higher interest rates from reduced government support would make it more difficult for Americans to become homeowners. This complaint is misguided, since the impact on interest rates from the Crapo-Johnson is the consequence of fixing the flaw in the old system that left taxpayers at risk: the higher cost for borrowers corresponds to the protection for taxpayers that was missing.

Moreover, Senators Crapo and Johnson address concerns over the impact of higher interest rates on low- and moderate-income families by including billions of dollars to subsidize affordable housing, both rental and owner-occupied.

Mortgage bankers argue alongside housing advocates for a private capital requirement of only 5 percent rather than 10. There is an irony in the apparent alliance, since groups that support affordable housing subsidies typically look skeptically at the role of large banks in the economy. Many left-leaning groups supported a past legislative proposal to impose a 15 percent capital requirement on megabanks, with the aim of protecting taxpayers against bailing out institutions that are too big to fail. Presumably their view is that the higher capital requirement would have only a modest negative impact on bank lending — the opposite of the argument that 10 percent capital would have a large impact on housing-related activity.

It would be hard to know the overall result for home buyers until the new system was in place, but the incremental impact on interest rates of having 10 percent private capital to protect taxpayers rather than 5 percent is likely to be modest. The first 5 percent of private capital slated to take losses would  be costly, because investors know their money is on the line in the event of another housing debacle. But this 5 percent private capital would be present under all legislative proposals.

The cost of the next 5 percent of private capital to take losses ahead of taxpayers is at issue. It takes only a moment’s reflection to recognize that the cost is likely to be modest once a new system with more capital is put into place over time.  The reasoning is that the sixth to tenth percentage points of private capital would be at risk only after the first 5 percent was wiped out. Or as I put it in testimony in October before the Senate Banking Committee, if 5 percent private capital is enough to protect taxpayers, then the next 5 percent private capital is safe and cannot be expensive. If the additional private capital is expensive, then it must be that 5 percent is not enough to protect taxpayers — it cannot be both ways.

The best estimates to date suggest that mortgage interest rates under the Crapo-Johnson proposal would rise less than half a percentage point compared to the current system.  By way of comparison, interest rates are likely to increase by multiple percentage points in the next two or three years as the Federal Reserve moves away from the zero interest rates in place since late 2008.  Just as Janet L. Yellen, the Fed chief, will be doing her job to return interest rates back to normal, so, too, will Congress by protecting taxpayers against another housing bailout.

One reasonable hesitation for undertaking any housing finance reform is that it would rearrange a sector of the economy central to the economic and social aspirations of American families. We have all seen the confusion created by the Affordable Care Act in forcing too many people to endure undesired changes in their insurance policies and choice of physicians, and setting the stage for galloping insurance premium increases in the future.

But the Crapo-Johnson bill is the opposite of Obamacare. It brings the private sector back into a housing finance system now dominated by the government. Market incentives rather than government officials would determine the availability of mortgage financing, allowing private investors to extend mortgage loans to potential home buyers who today are prevented from buying a home by the pendulum swing to overly strict post-crisis lending standards.  Indeed, bringing in considerable private capital will not just protect taxpayers, but also provide an incentive for prudence in lending on the part of investors whose money is at risk.

Without housing finance reform, the government will continue to dominate mortgage markets. The alternative to the Crapo-Johnson bill is not a fully private system but instead setting in concrete the current situation and thus effectively nationalizing the housing finance system.  A fully private mortgage market might seem attractive on paper, but it ignores the political and financial reality that any future Congress and President will act to stabilize mortgage markets if Americans cannot obtain home loans.

The government guarantee in housing is thus latent, even in a system that is ostensibly private. Pretending otherwise would inadvertently recreate a salient defect of the past: the implicit backstop under which shareholders and the management of Fannie and Freddie kept the upside in good times and taxpayers were stuck with the bill when the housing market collapsed — a $190 billion tab in the recent crisis. Rather than creating a system that is private only until the inevitable next crisis, it is thus preferable to make clear the government’s limited role and to ensure that an immense amount of private capital takes losses before another taxpayer bailout. Formalizing a taxpayer backstop on housing is anathema on the right, but it is the first and necessary step to shrinking the government’s role.

Democrats might hesitate at reducing the government role but applaud the innovative approach in the legislation under which mortgage companies have a financial incentive to serve all borrowers capable of sustaining a mortgage (and not just high-income families). This would be in addition to money for affordable housing activities through mechanisms created in the Housing and Economic Recovery Act of 2008 but that did not receive funds as a result of the financial difficulties at Fannie and Freddie.

A sticking point from the left is that many housing advocates expect Melvin L. Watt, the director of the Federal Housing Finance Agency, to put the money into affordable housing activities out of the now-considerable profits of Fannie and Freddie. Mr. Watt has the legal authority to do this now —  some would say that the 2008 law requires him to do so.  If the money for affordable housing flows ahead of broader reform, however, an important incentive for left-leaning stakeholders to support Crapo-Johnson would be removed.  It is ironic that action by Mr. Watt could actually undermine a measure supported by President Obama.

Reform of housing finance remains among the chief unaddressed legacies of the financial crisis. The Crapo-Johnson bill is truly a bipartisan compromise, satisfying neither side in whole but constituting a vast improvement over the current housing finance system in which taxpayers are at risk even while too many families cannot obtain mortgages.